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Monster Calculation
Reg NMS is also making waves in the securities industry because it potentially could revamp the formula that's currently used to redistribute market-data revenues back to SROs. In proposing a new allocation formula, the SEC is attempting to eliminate certain unethical behaviors, such as wash sales and tape-shredding, that are designed to increase market-data revenues but do not add value to price discovery.
With tape-shredding, a market participant that executes an order with 10,000 shares could report the trade in 100-share pieces. "A more egregious version of tape shredding is the wash sale," explains UNX's Brown, in which someone buys and sells the same security all day long so that many trades can be reported to the tape.
"It's manipulative behavior. It's seen as a problem because it's done for a sole purpose of increasing revenues," Celent's Burns says.
Today, the three market-data network disseminators - Network A for securities listed on the NYSE, Network B for securities listed on Amex and other national stock exchanges, and Network C for Nasdaq - allocate market-data revenue based on the number of trades that print on each exchange. Exchanges say they depend on these market-data revenues to fund their regulatory obligations. But in recent years, the National Stock Exchange (formerly the Cincinnati Stock Exchange) began redistributing its share of tape revenues back to ECNs and other firms that print trades on the exchange. To compete, the Boston Stock Exchange and Nasdaq started similar rebate programs.
While legal, these rebate programs distort the incentive for trading and actually encourage practices like tape-shredding. The SEC's proposed new formula, however, allocates revenues "among the SROs based on measures of the utility of their trades and quotes in the security," according to Reg NMS. More specifically, each SRO is entitled to an annual payment equal to the sum of the SRO's trading shares, quoting shares and NBBO improvement shares in each network security for the year.
The proposed formula, though, has been widely criticized as convoluted and overly complex, according to several sources that attended the SIA's Market Structure Conference on May 21. For example, to figure out how much revenue each network is entitled to relative to the trading of each security included in its data stream, the formula involves taking "the square root of the dollar volume of trading in each security," according to the proposal.
"The SEC had good intentions in designing this allocation so that it would remove the abuses that exist but, because there are so many loopholes they have to close, the end result became this monster calculation," Burns says.
Speaking at the SIA conference, Annette Nazareth, the SEC's director of market regulation, defended the formula. According to Burns, who attended the conference, Nazareth said the difficulty and cost of implementing the formula might have been overstated at the April 21 Reg NMS hearing.
In a document published May 20 - which extended the comment period for Reg NMS until June 30 and issued a supplemental request for comment - the SEC notes that the formula would not need to be calculated in real time and that only the processors (e.g., SIAC and Nasdaq) would need to deal with the formula directly. The SEC says the formula would not appear to impact any additional "downstream" systems costs on vendors or broker-dealers.
Despite the SEC's assurances, market participants still say the formula is too complex and would empower the securities information processors, namely SIAC and Nasdaq.
"It's just a very complex formula that would require massive computing power," says UNX's Brown. "It could be very difficult for the regional exchanges, ECNs or market centers to calculate and audit those numbers to verify the revenue split was fair and accurate," he adds.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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